Everyone I know is looking for the next stock market star -- the one buy that makes you rich. A true Hidden Gem. The acorn that finds its niche, surges into an oak, and reaches to the sky for years -- like Dell Computer (Nasdaq: DELL ) , up 350 times in 15 years, turning a $10,000 investment into $3.5 million today.
Peter Lynch called these stocks 10- and 20-baggers, and they make for great adventure, particularly when you don't have to take on much risk. And believe it or not, you don't. And yet too many investors do take on too much risk searching for the next big thing. Too often they speculate recklessly because they've never learned how to find, much less value, the most compelling companies.
The nest egg, not the shells
Here's the problem: Rather than study and emulate the strategies of the masters (Buffett, Graham, and Lynch), they gamble on low-quality story stocks. Having shunned research for whispers and rumors, they're left holding the broken eggshells of fourth-rate hyped growth stocks rather than a nest egg of great companies churning out market-punishing returns.
Let's make sure you end up with the growing nest, not the broken shells.
Over the years, I've developed a number of basic principles that have helped me do just that. These principles are the foundation of my Hidden Gems style of investing and guide me as I screen the universe of small-cap stocks for the most likely 10-, 20-, and 50-baggers of the next decade. Let's focus on three -- criteria first, then hidden gems.
1. Significant insider ownership
I'm always surprised at how many investors are uninterested in a company's ownership structure. Significant insider ownership is a primary driver of superior, long-term returns. After all, doesn't a neighbor take better care of his home than, say, the tenants at Delta Theta Ki fraternity?
The same is true with companies. It's no fluke that Microsoft (Nasdaq: MSFT ) has created thousands of millionaires over the past 20 years, while founder and leader Bill Gates sits on more than 1 billion shares. When insider hands hold the stock, you're much less likely to learn of a multimillion-dollar birthday bash -- remember Tyco (NYSE: TYC ) ? Insider holdings increase the probability that a business is run in the long-term interest of shareowners.
Criteria One: Insider ownership should exceed 20%.
2. Generous return on assets (ROA)
Too many investors are so tightly focused on earnings per share that they disregard the fundamental drivers of real value. Among the most important and least studied of these is a company's return on assets. Simply put, this measures how much profit a company creates for each dollar of assets. Divide net income by total assets and you have a basic read on management effectiveness.
If you concentrate on companies that generate more than 10 cents of profit for every $1 of assets, you'll narrow the universe of stocks to the most adaptable and profitable companies in America. A company like Dell, with a strong competitive advantage in inventory management, boasts a return on assets above 15%. Conversely, beleaguered General Motors (NYSE: GM ) , beset by competition and forever struggling with labor issues, returns south of 1%. Little wonder, GM traded higher in 1994 than it does today.
Criteria Two: Returns on assets north of 10%.
3. Little institutional attention
Finally, I love to find small-cap stocks followed by fewer than five analysts. I particularly like it when total institutional ownership is south of 25%. This provides us, as private investors, a chance to get in ahead of the big-money mutual fund and pension fund managers.
My most successful Hidden Gems recommendation is up more than 120% in two months. Institutional ownership of the business is less than 15% and no analysts follow the company. Compare that to ExxonMobil (NYSE: XOM ) , majority owned by investment firms, its every move followed by 25 analysts. It's extremely difficult to get a competitive advantage when the whole world is watching.
Criteria Three: Fewer than five analysts following and less than 40% institutionally owned.
Three rising stars
Now the payoff -- three companies that make the grade. Moreover, all three satisfy the more than two dozen other factors I consider before recommending any stock. I don't own positions in any, but all three have been featured on my short Hidden Gems Watch List:
Craftmade (Nasdaq: CRFT ) , a maker of ceiling fans and light fixtures, has smashed the market's average return over the past 10 years. Just five analysts cover the stock, insiders own a big chunk, and management delivers a 16% return on assets. Craftmade was featured at $22 in our October issue. It now trades at $25. I believe it will be worth more than $40 within the next few years.
Papa John's (Nasdaq: PZZA ) has battled through some nasty pizza price wars, but sales are beginning to rebound. Hefty insider ownership, a 10% return on assets, and just four analysts on board further pique my interest. Featured at $25.83 in our September issue, the stock trades at $27 today. So there's still time. I believe the stock is worth more than $50 over the next three years.
Healthcare Services Group (Nasdaq: HCSG ) , a leading provider of housekeeping, linen, laundry, and food services to nursing homes and retirement facilities, is exceptionally well run. It's also playing right into some major demographic trends. The company has marginally lower insider holdings and returns on assets than I'd prefer, but only two analysts follow the stock, which was featured in our September issue at $15.98. It trades today at $19, but I see it in the $27-$30 range over the next three years.
I don't make this stuff up. I've dedicated myself to the classic works of investors and teachers like Warren Buffett, Benjamin Graham, Peter Lynch, Bernard Baruch, Charles Royce, and dozens of others. Each made millions or billions applying simple mathematical logic, an enthusiasm for business, a knack for spotting an expanding market, and the patience to let their winners run. I return to them each month when selecting my Hidden Gems recommendations.
If you would like to read more about my approach, and study my Hidden Gems recommendations to date, you can take a free 30-day trial with no obligation to subscribe by clicking here.
Give it a whirl on me. I think you'll enjoy it.
Tom Gardner is co-founder of The Motley Fool, which has adisclosurepolicy.